On Free Lunches - The First Pillar of Economic Wisdom

[danieldwilliam]

I’m going to amuse myself by considering what I’m reminded of by each of the Ten Pillars of Economic Wisdom.

The first of the Ten Pillars of Wisdom is TANSTAAFL.

There Ain’t No Such  Thing As A Free Lunch.

If economics is the study of the creation, transfer and exchange of value than this pillar reminds us that none of that creation, transfer or exchange comes without a cost.

Usually, that cost is pretty explicit. Party A trades Item X for Item Z from Party B. You exchange a fraction of an hour of labour for £3 and then exchange that £3 for a  pint of beer. (1)

Sometimes the cost is implicit in some way. The “cost” of being a recipient of welfare transfers is that you don’t riot and agree to have yourself painted as drooling, feckless, greedy, lazy, cunning, stupid vermin.

Sometimes the cost is more subtle. Some assets have a cost associated with owning them.  If I own a bar of gold I need somewhere safe to keep it. If I own a car I need to pay for road tax, insurance and periodic MOT’s. If I sell those assets, or give them away I avoid the costs of ownership.

There are also costs associated with transforming a hard to sell asset into cash. If I own a large country house it takes time and effort and estate agency fees to turn it into several million pounds. If I’ve just inherited the house and I don’t particularly want it it might be easier to gift it to the nation in lieu of inheritance tax rather than sell it and use most of the cash to settle the tax bill. (3)

Often  not a thing that is exchanged but the risk of a thing happening. In exchange for £X my building insurer takes on the risk of my house burning down. If I sell an option contract then I am trading cash for the risk that the price of a commodity will move. When MLW and I bought our flat we were prepared to pay what we paid for it partly because of its location and the effect that its location had on the likely future value of the flat should we have to sell it. We reasoned that a flat overlooking a park in the centre of beautiful Edinburgh bought near the top of the housing market was more likely to hold its cash value than a similar flat overlooking a railway line two miles out of town. We traded actual cash now for the likelihood that we would not have the difficulties of negative equity in ten year’s time. We’ve improved our position in the contingent event of the housing market collapsing and our having to sell our house to move to another city.

So far, so good. We’re exchanging things for lunch. The lunch is pretty good so we don’t mind but we’re definitely paying for it.

What about pure donation? The gift given free and gratis from altruism or love. I’m not about to suggest that love and altruism don’t exist. I’m more than happy to accept that there are transfers where all the value moves from one party to the other.

If one of my children needed a kidney I’d be happy to donate one of mine. Even if they never spoke to me again afterwards I’d do it. The cost to me is pretty obvious. I’m down a kidney but, so long as I’m healthy I only need one kidney so the cost is relatively small compared to the health of one of my children.  Why don’t I offer a kidney to the first one of my children to fall even slightly ill.

The reason is that in any transfer of value, even one that is a pure donation, there is a hidden cost. If I give my kidney to my slightly ill son I can’t in the future donate it to my very, very ill daughter. The cost of being a loving father today is to restrict my opportunities to be a loving father in the future.

Opportunity cost is the cost of the next best thing I could have done with the resources I used to do the thing I actually did. (2) Not only does an economic action usually cost me something of value but it always costs me the opportunity to do something else with those resources of time, money, talent, physical stuff and pschological energy.

The idea of opportunity cost still holds true for things that I don’t value at all. I have a friend who occassionally and very generously passes me one of her old theatre books. I think she feels better that the book is going to a home that will love it and that she now has less stuff and more room in her life.  She’s actually better off without the book. But still there is a cost. When she gives the book to me she can now no longer give the same book to another theatrical friend. The cost to her is reduction in choice about who gets the book. The cost might be small. It might be well worth paying for the warm fuzzy feeling she gets when I love her gift and the extra space on her bookshelf. She is forever denied the opportunity of lending that book to someone as the opening gambit in a life changing relationship.

Opportunity cost is a key determinate in search strategies.  You could buy the perfect pair of shoes right now or you could spend all day looking for the same shoes for £5 less. Is a day shopping for a pair of shoes worth the chance of saving £5 to you? 

There is no such thing as a free lunch – at the very least what looks like a free lunch has cost you the chance to eat somewhere else.

So as a student of economics or an amatuer economic anthropologist what is the take away from the first pillar?

First, keep an eye out for hidden, subtle and contingent exchanges. If you see a transaction that looks like it is giving someone something for free dig a little deeper and see if there is a contingency for one side that is improved by the transaction. Have they reduced a risk or increased an opportunity. If you think the price for something is too high or too low look for the less obvious things that are valuable in the transaction. Are they more valuable to one side than the other? Do both sides agree that the object being transferred is the same thing? How much would it cost the parties to do a different deal with different people.

Second, never forget that opportunity cost is always there. Even doing nothing is not free.

(1) Unless you live in London, in which case replace £3 with £5 and beer with dishwasher effluent.

(2) The opportunity of cost of reading this essay on the internet is that you could have been looking at something else on the internet. Don’t worry, I won’t tell you mother.

(3) and that’s how the National Trust ends up with so many houses that they stopped accepting them.

Comments

Timeo Danaos et dona ferentes

[f4f3.livejournal.com]

I remember being terribly impressed by TANSTAAFL when I came across it in Heinlein. I think he was talking about the three laws of thermodynamics (also paraphrased elsewhere in poker terms as "You can't win, you can't break even, and you can't even quit the game").

Then I realised it was a pretty mean-spirited way for Libertarians to trash any form of support for anyone who wasn't them. So I'm a bit biased about it. I agree that if you look at any exchange between humans then you can find a little bit of extra value being picked up by one of them. And that's handy, if you're looking for fairness - I loved contract law for that very reason.

If you apply it everywhere then life seems to be a bit transactional...

(Oh, and I'm really enjoying these posts)